(In late May, 2020 and with over $20 billion in debt, Hertz resorted to Chapter 11 bankruptcy to reorganize its business, improve its capital structure and buy time during the pandemic.)
In May, J.C. Penney Company and Hertz Global filed. Others in 2020 include Neimann Marcus and J.C. Crew. Market watchers and bond investors try to project who's next by providing drive-by analysis or injecting opinion into capital markets (via rising yields in corporate bonds and increases in "credit spreads" in credit derivatives). Airlines LatAm and Avianca have filed.
Bloomberg reports at least 98 global companies with debt of at least $50 million have filed for bankruptcy in the first five months of 2020. Other familiar American filings include Dean & Deluca, Borden Dairy, Modell's, Pier 1, and Gold's Gym. There can no longer be a stigma of failure when a company submits papers for Chapter 11.
Some bankrupt names are victims of the pandemic. Their business models are based on social contact and constant interaction among humans. They might have been thriving businesses until revenues evaporated suddenly after February. Other bankrupt names (Pier 1, Modell's, e.g.) were vulnerable all along, barely surviving businesses that had been candidates for insolvency for a long time. A coronavirus scenarios merely thrust it off the cliff.
Take the rental-car agency Hertz. CoViD-19 has ravaged its business, because people aren't traveling on business or for pleasure. In mid-May, it missed a payment on debt due and requested extensions from its banks and a restructuring of the loan, an extension in some way. By late May after having asked its CEO to resign, it resorted to a formal Chapter 11 filing.
For others, it wasn't about CoViD-19; it was about changing tides within the industry. Either companies were evolving or they had begun a slow crawl toward the end of existence. Before March, a long list of names in the retail and consumer products industry were candidates for bankruptcy. They include the familiar department-store names, brick-and-mortar businesses that hadn't quite embraced Internet shopping. This industry has been embattled for a long time. Some companies casually glanced at the explosive surge of online shopping in the past decade without bothering to embrace it or compete.
Its woes are blamed, too, on their reluctance to embrace a different way for consumers to purchase goods. Some in the industry tried to transition into online sales, but did so too late. Even Sears had embarked upon an online strategy, but its early hesitance led to the downfall of a company deeply embedded in American business history. That company filed for bankruptcy two years ago.
Other retail-industry companies were able to survive as barely break-even enterprises, scrounging for ways to come up with a miracle that might boost annual sales at least by 5-10 percent annually. They might been able to squeeze a year or two of solvency or sell themselves to an optimistic private-equity firm--until CoViD appeared.
Rating agencies have tried to project default rates among non-investment grades after the beginning of the pandemic. Default rates reported range from 8-14%, depending on the industry or country. That doesn't imply14% of corporates rated BB+ or lower will end up in bankruptcy. But they become candidates. Defaults initially lead to efforts by both parties to restructure or extend debt due. Many lenders and investors seek to resolve an initial problem before bankruptcy becomes a final resort.
Watch closely, too, WeWork. Its near collapse in 2019 after it had prepared for a celebrated IPO was well chronicled. A faulty business structure and fragile balance sheet put it on the precipice of insolvency. It will continue to struggle throughout 2020-21.
JC Penney's Woes
JC Penney was certainly one of those names. Others like Macy's or The Gap might be candidates further along.
JCPenney is a name that could have managed survival before CoViD-19, despite its stumbles in updating business models and strategies the past decade. Unlike other retail companies, for the past eight years, it has managed to hang onto sales at $11-12 billion annually. Business wasn't growing, but it wasn't disappearing in sharp down-steps. (By comparison, annual revenues at Sears fell by 60% in the last five years before its filing for bankruptcy.)
JCPenney suffered accounting losses, but when a company is struggling to survive, it's less about GAAP income and more about actual cash inflow. (Many companies, as we've observed the past decade, present GAAP results, but switch quickly to non-GAAP presentations of performance to show cash flows and often to show the best of themselves in whatever manner possible. Accountants permit these non-GAAP reports of performance, as long as the company explicitly states the adjusted earnings don't meet conventional standards.)
For the past five years, the company consistently generated operating cash over $400 million each year. Much of that cash each year was deployed to fund capital expenditures, often cash outlays to maintain or upgrade old stores. It sold other investments to gain cash to pay down some debt. But debt still totaled over $3.5 billion at the start of this year.
The company had little room for error and held onto an embarrassingly low amount of cash reserves for a company operating across the country (less than $400 million). With a small amount of cash on hand, CoViD-19 was the misfortune it couldn't afford to encounter. Its $12 billion-revenue business probably won't top $6 billion in 2020, while fixed store costs will remain the same until they can sell properties that will be shut down. The $400 million in operating cash flow of last year will more likely become $400 million in cash deficit in 2020.
While the evaporation of business activity in March-April, 2020, will be the blame for many insolvencies, highly leveraged balance sheets will have been the symptom that pushed them into the courtroom. JCPenney might have been able to conserve about $100 million in cash annually if it had about half the amount of debt it had by the end of 2019.
Bankruptcy (the Chapter 11 version) is about devising a plan for how it will proceed (and how it will generate cash flow to appease creditors). Because revenues won't grow anytime soon, the company will shut down stores to reduce fixed costs and consider selling related assets. It had done so in the past, but not in the aggressive way it must do so now.
In May, it announced it will sell 30% of its stores over the next two years. Selling stores reduces fixed costs, but it subtracts off substantial amounts in revenues. It also wants to present a polished plan to emphasize online sales, activity that had heretofore contributed modest amounts to total revenues. Sears, nonetheless, in its waning years before bankruptcy had tried a similar path and made similar promises.
How to Remain Solvent?
The retail industry won't be the only industry to get pummeled in these times. Businesses in such industries as hospitality, entertainment, travel and airlines are similarly vulnerable. In the first wave, companies that were already struggling with low cash flow or tenuous business models will seek bankruptcy protection.
A second wave could follow for companies that had been sturdy and relatively strong before the crisis. Because they had sufficient cash reserves and manageable debt levels, they can survive a short-term downturn. Eventually cash runs out more quickly than revenues recover to pre-crisis levels.
Companies that exhibit the following will have the best chance of remaining solvent and staying away from bankruptcy:
a) Cash on hand and operating leverage. Companies with adequate cash reserves to manage operating expenses with negative growth in revenues over a 6-12-month period put themselves on good footing. Many large companies have stockpiles of cash, although they may have been earmarked for other activities. Unencumbered cash is always a short-term solution at least until an economy starts to rebound. (In early 2020, Tesla entered the crisis with over $6 billion in unencumbered cash. Goodyear Tire has about $4 billion if the availability under a committed revolving-credit facility is included. Netflix has over $5 billion.)
With the cash on hand, they can meet operating expenses comfortably if they have manageable levels of fixed and variable costs and relatively low cost structures. Companies are in better shape if fixed costs are relatively low (vs. total costs) and if variable costs can disappear as rapidly as declining revenues.
b) Low leverage. Companies with insignificant amounts of debt can avoid insolvency. Bankruptcy is technically a way for borrowers to manage the demands of creditors. Low leverage reduces the amount of cash payouts to creditors and the likelihood creditors will push for default resolution. Leverage is measured in so many ways: Debt/Ebitda, Debt/Equity, Debt/Operating-Cash-Flow, Free-Cash-Flow/Current-Debt-Payments.
In early 2020, ratings agencies and investment analysts were reporting Debt/Ebitda ratios rising slightly, but below 6 for leveraged-finance transactions.
In 2019, by these ratio standards, JCPenney had high leverage: Debt/Ebitda > 6, Debt/Equity = 4, Debt/Operating-Cash-Flow = 8. In 2020, those metrics were only going to worst and worst, as cash flow deteriorates.
c) Debt refinancing and debt tenors. In good times, investment-grade companies expect to pay down expiring debt by refinancing the debt. In good times, non-investment-grade companies also expect to refinance most debt. (Netflix, a non-investment-grade name, has $15 billion in debt and typically plans to roll it over when due and use operating cash flow to continue to finance its growth spurt.)
In bad tines, non-investment-grade companies must plan for expiring debt not to roll over and must show they can pay down what's due.
If the principal on the debt is due in more than two years to come, struggling companies can breathe more easily by paying interest and hoping for eventual revenue upturns. JCPenney, for example, always managed a way to pay annual interest of about $300 million in the last few years--before the pandemic.
The "refinancing wall," thus, determines the level of problems a highly leveraged company can have: What amount of long-term debt is due within the next 12-24 months? (Investment-grade name Merck has $22 billion in debt, about $8 billion due in the next three years.)
d) Revenue decline. How quickly will revenues decrease--slowly, gradually, rapidly? Airlines, hotels and certain entertainment companies observed their sales erase overnight--in large percentage chunks.
For companies in other industries, revenues are slipping away slowly as the impact of recession affects their customer bases. Customers with long-term sales contracts or operating in low-risk industries might not experience revenue implosion immediately. Some companies with diversified revenue sources may suffer a less dramatic drop-off in sales.
Other companies took a sharp turn in repurposed the business or product in the interim to meet pandemic-related demand for other services. Uber has begun to focus on UberEats. Some manufacturers reengineered product lines to become makers of hand sanitizer, protection equipment, etc.
Hertz Global Files for Chapter 11
Hertz's suffering was caused by a global lockdown on travel--whether for business or pleasure. Yet excessively high leverage shoved it into bankruptcy court. The company had increased its debt burden by 2019 to over $20 billion (including obligations on operating leases). Almost all of that debt funds its fleet of vehicles around the world. (Debt/Equity at March 30 computed to an overwhelming 13.7. Its Debt/Ebitda was not a meaningful ratio because of recent operating losses.)
Hertz's operating model is built around ensuring vehicles are in use frequently, rented out to customers for the maximum amount of time. Utilization of vehicles before CoViD-19 had been above 70%; in late March, utilization was sliding to 60%. By May, utilization may have fallen below 50%. Even as the pandemic wanes and travel increases gradually, the company can't expect utilization to rise back above 70% in 2020 and early 2021.
(Hertz also operates via franchises, which too will have suffered similar decline in activity.)
Cash is also generated from selling an aged fleet of cars. Cash flow from that source (normally about $2 billion/quarter) will also deplete in the short term.
Before it filed, Hertz did what many large companies did to prepare for the onslaught of the coronavirus: It drew down on bank-led revolving-credit facilities. That permitted Hertz to confront a CoViD-19 environment with other $1 billion in cash. But that amount can't offset the substantial operating deficits it expects in the coming months.
The company has some favorable factors: (a) It has a globally known brand, which provides in multiple ways, and (b) it has the ability to bounce back quickly when people are comfortable traveling again. Hence, it is in a waiting game and hopes creditors can wait, too. Can it keep costs to a minimum until revenues return perhaps to near 2019 levels? When will revenues return--2021, 2022? Can utilization approach 70% again? And when will that be?
Advisory Firms
In bankruptcy and insolvency scenarios, banks play many roles. They are lenders and creditors who line up to stake their claims on the borrower's assets. They are also fund-providers, providing debtor-in-possession financing (often working-capital funding), a short-term source as the company and court work through the process. Or as investment banks, they may be advisers, assisting the borrower in identifying cash sources and restructuring the business and the balance sheet.
Many advisers are boutique firms, not likely to have been lenders and counterparties to the borrower and able to act independently. Some advisers are firms that specialize entirely in restructuring and bankruptcies (Alix Partners, Alvarez and Marsand, e.g.).
Other advisers are investment banks with reputable positions in mergers, acquisitions, and underwriting. In down times, they switch tunes to focus on restructuring by devoting more resources and pitching related services.
Lazard has a prominent restructuring group. Fees from this activity will offset the expected decline in merger advisory and underwriting. In its latest annual report, not anticipating the major downturn at that time, it described how it represents the borrower or the creditors. The practice is divided into before bankruptcy advisory work and after bankruptcy advisory.
In periods of distress and before filing, Lazard will determine current debt capacity of the company and then advise how best to restructure its balance sheet while working with bankers and investors. In bankruptcy, Lazard advises the company on reorganization planning and strategy. That could include the issue and structure of new securities. The firm generated $1.1 billion in investment banking fees last year, but it doesn't disclose what portion of that is derived from the restructuring and bankruptcy business.
Other boutiques, such as Evercore and Moelis, also push the restructuring business to the front when companies scramble to keep businesses solvent before filing. Moelis, in fact, will assist Hertz. It's not unusual that senior bankers who step into these roles are former bankruptcy attorneys.
Tracy Williams
CFN: Radio Shack Files for Bankruptcy, 2015
CFN: Yahoo Tosses in the Towel, 2016
CFN: MF Global: Too Small to Save, 2011
CFN: Are Corporate Borrowers Prepared for CoVID-19 Scenarios? 2020
CFN: WeWork: What Happened and Why? 2019
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